Wednesday, February 25, 2009

Zombies Must Die

The government taking over a bank presents plenty of problems. Among the challenges, Federal Reserve Chairman Ben Bernanke said this week, is “that you tend to lose the franchise value, that the counterparties and others don’t want to deal with you because they don’t know your future.”

—The Wall Street Journal, February 20, 2009 [emphasis added]

Those are the words of the current Fed Chairman, and we are not making them up.

According to Mr. Bernanke, Citigroup—CitiSmorgasbord, as we like to call it—has a “franchise value” that might be “lost” if the U.S. Government took over what Wall Street has marked down to a per-share price of less than the loose change in your pocket.

In fact, at yesterday’s close of slightly north of $2.50 a share, you could give up your morning Starbucks latte and instead buy a share of Citigroup stock, with enough change left over to buy a share of Fannie Mae, if you really wanted to speculate.

How’s that for “franchise value”?

Now, we here at NotMakingThisUp don’t take Citigroup, or its franchise, lightly. Our business happens have an account ensconced within the computerized bowels of that firm. So we’d like very much to see the place survive.Still, we have our doubts.

Created Frankenstein-like by Former Master of the Universe Sandy Weill, who extracted about a billion dollars from the place before sailing off into the sunset just a few short years ago, CitiSmorgasbord is in its current form little more than a zombie bank—the kind of lifeless, destructive financial force U.S. wonks used to make fun of when they roamed Japan years ago.

(We don’t bring up Mr. Weill’s name lightly. Indeed, we find the furor kicked up over the $400 million “CitiField” fiasco supremely ironic, given that Weill himself has been slapping his name on buildings at places like Cornell University, thanks to the far-more-than $400 million dollars the same firm paid him during its heyday, before the era he helped perpetuate came to grief.)

While Citigroup indeed has a franchise, and maybe several, we have no confidence that the “franchise value” of Weill’s Balkanized Empire—net of all liabilities, seen and unseen—is much more than the current market price.

In fact, we worry it may be much less. A quick look at the months-old balance sheet tells us that at September 30, 2008, Citigroup had nearly a trillion in debt, with shareholder’s equity of $126 billion.

Berkshire Hathaway, meanwhile, had almost exactly the same shareholder’s equity, at $120 billion, but only a twentieth of the debt: $47 billion, to be exact.

Which financial services firm would you rather do business with?

Given that we cannot bank with Berkshire Hathaway, however, we here at NotMakingThisUp have in fact made sure our deposits at CitiSmorgasbord are below the FDIC-guaranteed threshold—just in case.

And that’s the guts of the problem, that “just in case.” Because everybody from bond traders to hedge funds to plain old checking account holders are wondering about “just in case,” and acting accordingly.In light of that persistent drain of both goodwill and cash, will Citigroup’s so-called “franchise value” prove any more enduring than the “franchise value” of Washington Mutual, or Wachovia, or Lehman Brothers proved to be?

Beats us.

Still, while we have no rooting interest in the stock itself, nor in any other ailing institution whose main business was lending money with abandon, paying whopping bonuses to the men and women who lent the money, then writing off the loans, firing the men and women who lent the money, and asking the government for help, we do have an interest in seeing the American economy stop bleeding.And it seems to us the best, simplest and most direct way to do this is to do exactly what the new Administration has said it does not want to do: nationalize the zombie banks.

The notion that Citigroup and any other zombie bank could be less badly run under a Government shareholder than they have been under ownership by the Fidelitys and Vanguards of the world, is hard to fathom. Bernanke’s concern that the “franchise value” of the Balkan Empire that is CitiSmorgasbord would somehow be lost seems to us the figment of a fevered imagination clouded by too many white papers.

So why not get it over with already? Wipe out the shareholders whose job it was to hire managers to run the business effectively, and preserve for the taxpayers whatever potential upside might come as owner, rather than merely absorbing all the downside as lender-of-last-resort.

Knowing the U.S. Government backing is not only implied but tangible, depositors would feel better about their deposits and creditors would feel better about their credits.

And Bernanke’s argument that “the counterparties and others don’t want to deal with you because they don’t know your future,” would evaporate, because right now those counterparties don’t have a clue what Citigroup’s future is.

Nationalized, they would know that the floor was in, and credit default swaps would drop from the 460 level to whatever the U.S. default swap is running these days. Markets could focus on rebuilding—not on speculating about what-more-bad-news-might-happen-tomorrow.

The only “franchise value” worth protecting here is not that of CitiSmorgasbord or any of the other zombie banks roaming Wall Street: it is the franchise value of the United States of America. And the best way to stabilize the patient is to stop the hemorrhaging, and get the blood flowing to the rest of the body. And to do that, the zombies must die.

The content contained in this blog represents the opinions of Mr. Matthews.Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.

9 comments:

Ken Kuttner
said...

I hate to disagree with Ben, but in my view nationalization should make counterparties more willing to deal with Citi, and other zombies. In the nationalization scenario, counterparties would be reassured that Citi wouldn't stop functioning the next day, hanging the counterparties out to dry. No panic, as there was in the case of Bear.

Nice piece, Jeff. You and I could not agree more. Absent full transparency (which would plainly demonstrate the lack of solvency of CitiBomb and several other Top 10 firms), serious clients will not want to deal with them. As to Ben's "franchise value" comment, by which I think he means Goodwill, I think it is fair to say that Citigroup is trading at, well, a pretty steep discount to hard book. If only we knew what hard book really was.

Are you making the argument for nationalization? I was hoping that you were instead making the argument for outright bankruptcy and reorg (with government guarantee of deposits in place). That would be far better, and far cheaper for taxpayers. It would wipe out the current shareholders, replacing them with the creditors. What is wrong with this? Nothing, except that the current shareholders of the big banks have tremendous power with the likes of Franks, Obama, Geitner, Bernanke, and on and on, and that's why it isn't happening.

For starters, the "current shareholders of the big banks" that you fear have so much "power" in D.C. have, in fact, already been virtually wiped out. Citigroup is down from $55 a share to $2.50, if you hadn't noticed.

Second, a bankruptcy filing of Citigroup would be a complete disaster.

Recall how the September 2008 Lehman bankruptcy triggered a free-fall in the world economy starting in October.

Then imagine Citigroup filing. If you thought Lehman was bad--and it was mind-boggling--a bankruptcy of this major money-center bank would make your head hurt.

No, a bankruptcy filing would help nobody--not you, not your fellow taxpayers, not Barney Frank, not Ralph Nader, and especially not the U.S. economy.

It would, instead, turn the "Great Recession" into the "Great Depression II."

I suspect a nationalization would have similar consequences to a bankruptcy filing. Mostly because nobody knows exactly what "nationalization" means. If it means the government takes "control" of the entity well, then common shareholders are certainly getting wiped out (though long term holders already have been). What happens to preferreds? Especially those that invested alongside the government? Do bondholders take a bath as well? Does the "nationalization" effectively mean all liabilities of the bank are now government liabilities? That would result in customers abandoning healthier banks and flocking to the newly minted "risk-free" Citi. So does the government take over BofA next? Then what about JPM? Are the insurance companies next? All this seems to me a recipe for confusion, because, again NOBODY KNOWS WHAT NATIONALIZATION MEANS. And that's a huge problem, because markets hate uncertainty, confusion, rule changes in the middle of the game, etc. And our government servants in Washington haven't exactly been crisp and clear in their communications lately. So if you want market turmoil - well, a Citi "nationalization" would be the mother of uncertainty. Maybe Tim "I gotta plan" Geithner could deliver that message to...

And do you really think a government that is responsible for the even-bigger mess that is Fannie and Freddie is qualified to run Citi?? C'mon! The country is going to go bankrupt in 20 years over entitlement payments because of the spineless idiocy of our elected officials!

"badly run under a Government shareholder than they have been under ownership by the Fidelitys and Vanguards of the world"

Not sure where you're heading with this. The F/V's of the world don't care what they own as long as they can own a lot of it. If you haven't noticed, they get paid off AUM, not performance - the latter is only relevant to marketing materials.

Also, State Street and Barclays are the largest shareholders in Citi. I consider it to be a travesty that the priests of EMH pushed ETFs so hard that you have stupid ownership (and for smaller ETFs, the index designers create huge mispricings).

If it's not perfectly obvious to all concerned --- these instruments make it impossible for concerned shareholders to purchase a controlling share at a decent price.

I'm not a fan of the Treasury boys, but at least you have some form of shareholder consideration as opposed to none (I don't think the Fidelity analysts are feeling too bad at having lost their clients' money. And Bill Mason continues to be, Bill Mason)

I figure there are 5 options at this point 1) Obama is getting poor advice from his economic team who in turn somehow believe they can just turn back to the clock to the days of Allan Bubblespan. 2) Obama is more corrupt than I thought and knows zombie banks will lead to Japan style stagflation but has been paid not to care. 3) Sometime last year during the TARP and merger period the treasury and/or fed made explicit promises to not let any of the current players go under 4) Obama and his team know the zombie banks are insolvent and will be a drag on the US economy for years but have run the CDS numbers and believe trying to settle the 64 TRILLION in derivatives would be worse 5) Obama and his team know the top 5 banks are zombies and want to nationalize them but are taking the FDR approach. "I agree with you, I want to do it, now make me do it." Franklin D. Roosevelt Comment to a group of reformers.